Takeover Laws and Financial Development
Tatiana Nenova[1]
Abstract: The issue of “an appropriate” legal framework, especially in the case of the takeover market, has been poorly studied in the case of emerging markets, yet it is of immediate relevance and practical policymaker interest. The study makes a first attempt to analyze takeover regulations in a comparative context across 50 countries. It proposes a methodology to create a detailed index on the most salient features of capital market laws, and illustrates the approach on the case of takeover legislation. The methodology allows better understanding of the impact of laws on markets and development, allows a detailed quantification of a given regulation, in this case takeover market rules, and helps determine relevant policy implications. Specifically, the framework permits the exploration of the effects of individual regulations, their substitutability and interplay, as well as the overall extent of friendliness of the laws to investors, or particular groups thereof (such as minority shareholders), and the links of specialized regulation with the overall legal system. Finally, the study explores the effect of the investor-friendliness of takeover laws on stock market development.
Capital markets are essential to the growth and development of a country’s economy.[1] First, they channel available funds towards growing businesses (funds may be available from corporate shareholders, domestic and foreign investors, pension funds, banks, insurance companies, or other institutional investors). Second, such markets fill in the gaps left by bank financing, which may not be offered at long maturities and often requires costly and scarce collateral. Equity financing, better than banks, can assume the risk of young fast-growing innovative businesses (such as the challenger airline in Brazil, GOL), which are in need of significant funds, and have grown beyond the self-financing pocket of their owner / entrepreneur, but are too risky for a single bank to finance, and too large for a venture capital firm to engage in. Third, capital markets provide a diversification strategy and growth outlet for key players in a nation’s economy, such as pension funds, which can develop only in the presence of a set of markets that would permit their portfolio to reduce risk and reap returns for the beneficiaries.
Capital markets therefore have been a priority focus of national development strategies in the past 15 years. However, past experience shows that promoting a well-functioning and stable capital market that is effective in raising external financing has been an elusive goal for many countries. Policymakers have emphasized the importance of an appropriate regulatory framework to the successful pursuit of a capital markets development strategy. Two studies in the late 1990s first demonstrated convincingly in a cross-country context that laws and financial markets regulation have a tangible and important impact on markets and financial development (La Porta et al 1997, 1998). A veritable flood of research on the impact of laws and regulations on capital markets followed, further deepening our understanding of the area. In addition to cross-country studies, single-country research has been abundant, often focused on the US or UK, and other OECD countries, and recently complemented by research on Brazil, India, and Russia, on a wide range of capital markets topics including corporate control and takeover issues.[2] Studies confirmed the importance of regulation for development. To name but one example, efficiently functioning legal frameworks were found to encourage firms to use external financing and grow. The literature also uncovered that markets do not react to the promulgated laws, but instead to the first signs of effective enforcement.[3]
Securities and corporate regulations present an entangled body of law which has been hard for academics to quantify in sufficient detail in order to study its impact on development and growth.[4] As a result, though we know of the overall importance of laws for financial development, it has been difficult for policymakers and researchers alike to draw specific conclusions on the impact of particular legal provisions. One reason for the paucity of cross-country studies of specific regulations is the sheer complexity of gathering and systematizing the data. The standard approach has been to identify legal provisions and codify them into quantifiable variables, such as the LLSV six-component anti-director index on investor protection.[5] On acquisition regulation, the sole cross-country index in existence is the Nenova (2001) three-component takeover rules index. The measures of regulations and laws used in such studies are too aggregated, however, and show a general level of legal protection. The measures do not reflect the regulations in detail; rather, they are useful in providing a proxy for the overall quality of capital markets rules. As such, the measures help in showing the importance of regulation and institutions; however, they are less informative on the pros and cons of specific legal mechanisms. Pioneering efforts in delving deeper into the body of law have been provided by World Bank’s Doing Business Report, which codifies specific regulations in cooperation with legal experts around the world. Topics of focus include company regulations on starting a business, labor laws, contract enforcement, creditor rights and information, bankruptcy, and investor protection, among others.[6] La Porta, Lopez-de-Silanes, and Shleifer (2006) is perhaps the work using the closest approach to this paper, in that it codifies the securities laws in 49 countries along several dimensions, and uses the newly formed variables to examine the effect of securities laws on stock market development.
This study takes a first step in the above direction by offering a methodology that would fully characterize the set of rules and regulations concerned with changes of corporate control, takeovers, tender offers, and general acquisition activity. Should the methodology prove successful, it is replicable for other facets of capital markets regulation. The framework, allowing a detailed quantification of a given regulation, in this case takeover market rules, permits the exploration of policy implications of the securities laws as they relate to share acquisitions. Specifically, one can explore the effects of individual regulations, their substitutability and interplay, as well as the overall extent of friendliness of the laws to investors, or particular groups thereof (such as minority shareholders), and the links of specialized regulation with the overall legal system. Finally, and most importantly, the methodology permits the study and demonstration of the impact of particular regulations on market development, in particular market breath and depth. This paper does not explore those issues in detail, and focuses instead on presenting the methodology and general uses of the new data; detailed exploration on specific regulations is relegated to further research. The issue of “an appropriate” legal framework, especially in the case of the takeover market, has been poorly studied in the case of emerging markets, yet it is of immediate relevance and practical interest, in particular in Latin America, East and South Asia, and Central Europe.
The literature exploring takeovers issues is extensive, and recent overviews are presented in Burkart and Panunzi (2006), Andrade, Mitchell and Stafford (2001), Bhagat, Shleifer and Vishny (1990), among others. Relevant literature is cited further along in the paper, as specific topics are discussed, e.g. mandatory offers or going private deals.
1. The market for corporate control
Corporate control transactions occur for several reasons. First, in the natural growth cycle of a company, the original entrepreneur may find his brainchild grown beyond the proportions of a small one-owner firm. Due to the need for additional financing, professional management, organizational complexity, costs of running the business, diversification motives, or any other idiosyncratic cause, the main owner may want to sell control of the company. Second, and related, the descendants of the original founder may wish to sever their ties with the family company, because there are succession issues, or the family is distanced from effective company management and does not feel comfortable with the risk exposure without commensurate control, so as to prefer to diversify their financial holdings into investments that would lower their overall risk of value loss. Control may also be sold to a multinational company, which brings in the know-how, marketing, and distribution channels that are inaccessible to a stand-alone firm. In countries with less concentrated ownership, control can be claimed in a hostile attempt, by a bidder who believes that company value can be enhanced. Friendly or hostile deals can also be executed for reasons of expected synergies between the acquirer and target.
Takeover laws are concerned with the orderly process of changes in control, their transparent conduct, equal opportunities for all investors, and “fair” treatment of all existing shareholders. Control is defined here conventionally as influence over corporate decision-making via a given number of votes in a general assembly.[2] Typical takeover laws require that any sizeable purchases of stock in a corporation be made via a tender offer (as opposed to open-market operations), on equal terms to all tendering shareholders, with any excess shares offered being pro-rated, so that every tendering investor has the same proportional chance of selling their shares to the bidder. Other elements of a takeover law would include fairness provisions on taking the company private, rules on equitable treatment of shareholders, as well as disclosure regulations. The law would also have a set of fairly intricate procedural steps and deadlines for the carrying-out of the tender offer itself. The use of anti-takeover tactics could also be limited in takeover regulations (a detailed example of a takeover law on the case of Chile is presented in Section 3). Specific characteristics of takeover laws are discussed in the Section 4.
Takeover regulation stands to resolve several major objectives, and different countries have in practice selected various solutions to these issues:
Objective 1: Allow companies to defend themselves. The optimal extent to which policymakers believe companies should be allowed to protect themselves against takeovers varies considerably. Defenders of a laissez-faire approach have adopted minimal takeover protection, in the belief that a company whose value may be improved by an outsider should become subject to such an improvement. The opposing view is that short-term value improvements may be detrimental to both the long-term stability of the company as well as other social goals important to policymakers, such as employee welfare, and therefore companies are allowed a considerable set of anti-takeover mechanisms in the law. The resolution of this issue in the legislative field is intimately related to the frequency of corporate control transactions in the capital markets.
Objective 2: Perform a “sentinel” corporate governance function. When a company is found undervalued, or “cheap” relative to what it could potentially be worth if it was run better, a corporate raider should find it profitable to purchase it, turn it around, and re-sell it at profit. Evidence is plentiful that takeovers address governance problems.[7] On the other hand, changes in corporate control have been criticized as an effective governance mechanism due to the free-rider problem, the danger of overpaying for the target company, and the exorbitant takeover cost which makes acquisitions useful only in correcting more serious governance problems.[8]
Objective 3: Ensure the fair division of value between controlling parties and minority investors. What is the appropriate definition of “fair” in this case? Fairness does not necessarily imply equal price. For one, controlling parties face costs of maintaining control that minority investors do not face. They have most of their wealth concentrated in their large stake in the firm stock, whereas other shareholders (such as pension funds) are well diversified. Further, controllers face fiduciary duties, the threat of lawsuits, etc. On the other hand, they may obtain benefits not available to the common investor, as well.
In discussing the fair division of corporate value among all takeover participants, it is useful to gain an idea of the magnitude of value available for distribution. Research shows that the value to be redistributed in takeovers, referred to as “control premium”, can be considerable. The control premium can reach 29% in Italy, and 20% in Switzerland. In contrast, it is less than 10% in Japan, Germany, UK and US, to name but a few countries. The control premium is potentially higher in emerging economies, where markets are less complete. It is 58% in the Czech Republic, 27% in Argentina, Colombia, and Venezuela, 48% in Korea, and 36% in Mexico.[9]
The issue of fair treatment of market participants involved in the takeover has been defined and resolved in a widely divergent manner in different countries. In France, the corporate owner and the minority shareholders receive the same price. In Brazil, before 1999 the sale price of control was not publicly disclosed, and minority shareholders did not share any takeover gains (estimated at around 25% of company value).[10] Sharing value with minority investors makes takeovers expensive, so they occur more rarely. The lower takeover threat could cause negligent managers to “relax” and fail to maximize company value. On the other hand, not sharing any value with minority shareholders may rob them from one of the few opportunities to receive a return on their investment, especially in less dynamic markets where dividends and capital gains are not abundant.
2. Investor protection during takeovers and market development
National legislations resolve in various ways the three objectives of takeover laws, and these policy choices affect the depth and breath of capital markets, and the willingness of minority investors to participate in the market. In addition to the effect of the laws, poor law enforcement further discourages stock market activity and development.[11] Appendix A presents a simple theoretical example that helps appreciate the validity of this argument.
The argument is not specific to takeover rules, and can equally well be applied to other securities laws. The appendix posits the following hypothesis: Breadth and depth of stock markets decrease with poorer investor protection, in particular with poorer protection of investor returns during takeovers. This hypothesis has been tested and confirmed in the case of several investor protection variables, as well as some acquisition-related variables. One example is Rossi and Volpin (2004) who find that countries with better investor protection have more takeovers, and more hostile deals, the latter explained by the fact that control is also less contestable in countries with low investor protection.[12] They also find that countries with lower investor protection experience more cross-border takeovers, and the volume of cross-border takeover activity increases with the difference in investor protection quality between countries.